Micro 4: Market structures – 5: Monopolistic Competition

1. Definition

The degree of competitiveness in a monopolistic competition industry is in between

that of perfect competiton and monopoly.

1) Number of Agents

• In perfect competition, there are large number of buyers and sellers (facilitated
by the free entry assumption). In monopoly, there are as many buyers as there are
in a competitive environment but only one seller (because of the barriers to
entry).

• In monopolistic competition, there are many buyers. This is similar to both Perfect
Competition and Monopoly.

• However, the number of sellers is considerably smaller than that in perfect

competition, but more than in a monopoly.

2) There is perfect Information and perfect mobility.

3) Nature of Goods

• For perfect competition and monopoly, we assume that the goods are identical, or
homogeneous.

• For monopolistic competition, we assume that the goods are differentiated, or

heterogeneous.

• This implies that the demand curve confronting each firm would be downward
slopping.

4) Barrier to Entry:

• There is no barrier to entry in the monopolistic competition industry.

• How does monopolistic competition market structure emerge? The answer lies in
the Removal of Market Entry. This can be understood in the following way.

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 • In the short run, the market is a monopoly market, controlled by a single firm.

• In the long run, the monopoly market structure disappears due to the market entry.
Ex post after the market entry, there are more than one single firm serving for the
market.

• However, the market does not become a perfectly competitive market structure
even the barriers to entry have been removed. As the products that firms in a
monopolistic competition industry produce are heterogeneous, each firm will thus
command some degree of market power in its respective market.

• This implies that the demand curve confronting each firm in a monopolistic
competition industry is still downward slopping. However, the demand
confronting firms in monopolistic competition would be flatter than the demand
under monopoly.

P
P P

Perfect Competition
D

DMonopolistic Competition
DMonopoly

x x x

2. Evolution of Monopolistic Competition Structure

• To fully understand this, let us go back to the monopolist market and ask what
exactly will happen to it when new firms enter the market.

• Initially, the market is served by a monopolist. It confronts a downward slopping

demand schedule. The monopolist is making positive economic profit.

• On its demand curve, if the monopolist raises the price by dP, the quantity sold to
its consumers will lose by dx. This is because people are only willing to pay higher
price for a smaller quantity.

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 Px
AC
MC MC i AC i
dx

dP
Px0

( )
AC x0

( )
MC x0 = MR x0 ( ) D0

x0 MR0 x

• As there is no market barrier in this industry, the positive profit thus attracts new
firms entering the industry.

• The entrance of new firms will imply two changes.

• First, the demand curve facing the incumbent monopolist would immediately shift
to the left to D1.

• This is because buyers have more choice now. For any level of price that the
incumbent monopolist sells, there bound to be less demand for its products.

Px
AC
MC M Ci AC i

Px0

( )
AC x0

( )
MC x0 = MR x0 ( ) D0

D1
MR0 x
x0i
MR1

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• However, not all of the existing customers will choose to shift to the new entrant.
Those who do not shift to the competing products sold by the new entrant are the
Loyal Customers.

• The final demand curve is D2 which is flatter than D1. D2 is also more elastic1 than
D1.

Px
AC
MC M Ci AC i

dx1 dx0

dP

D2

D1
x
MR1 MR2

• As long as there is profit to be made, new firms will keep entering the market
until the point where the demand schedule is tangent to the average cost and
price equals to average cost.

• Further, all firms will product at the new profit maximising level where its
MC=MR.

• In equilibrium, firms in a monopolistic competiton will produce at

MR = MC and P = AC

1
If you think carefully about the meaning of elasticity you will realise that, among other things,
elasticity represents choice. The more choices buyers have, the more elastic will be the demand
confronting the producer.

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 Px
AC
MC
MC
AC

AC ( x0 ) = Px0

MC ( x0 ) = MR ( x0 )
D

x
x0
MR

• In equilibrium, like the equilibrium under perfect competition, there is no profit

above normal to be made in the long-run.

• Unlike perfect competition, the equilibrium output under monopolistic

competition will be allocatively inefficient.

3. Allocative efficiency:

• The benchmark for allocative efficiency is that all firms in the industry producing
at the level of output where P = MC.

• When P = MC, market price reflects true cost of production.

• Under monopolistic competition, firms produce at the level of output where P >
MC. Thus, the equilibrium output in monopolistic competition is not allocatively
efficient.

• The degree of inefficiency can be shown by the distance between price and
marginal cost. The longer the distance, the less efficient the equilibrium outcome.

• The distance between price and marginal cost can also be used as a proxy to
measure the degree of monopolistic power under monopolistic completion.

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4. Impact of an increase in fix cost

Px
AC
MC
MC AC '
AC

B
Px1 = AC ' ( x0 )
Losses A
AC ( x0 ) = Px0

MC ( x0 ) = MR ( x0 )
D
D'
x
x0
MR ' MR

• Starting from the initial equilibrium where all firms make zero profit and produce
at x0 . Market equilibrium is at point A and the equilibrium price is Px0.

• When firms’ fixed cost increases, AC increases to AC ' and MC remains at the
same level.

• As neither MC nor MR has changed, firms will still produce at the initial level of
output but make losses of  Px0 − AC1 ( x0 )  × x0 .

• In the long run, with the losses, some firms will leave the industry and demand
facing each firm remaining in the industry will shift up and become steeper.

• At the new equilibrium, firms will produce at MC = MR ', AC ' = Px1 at point B. At
B, new AC curve is tangent to the new demand curve at the level of output that
where MC = MR1

• Notice that the distance between price and MC is longer now implying that the
new equilibrium is allocatively less efficient than before.

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Exercise:
Show that the equilibrium output can also be higher following an increase in fixed
cost in a monopolistic competition industry.

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Homework

1. Show that the equilibrium output is lower following an increase in fixed cost in a
monopolistic competition industry.

2. A lump-sum subsidy to a monopolist will have the same effect on price, output
and profits as it would for a firm in monopolistic competition, in the long-run.
True or false, explain.

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